After laying dormant for more than two decades, the rare disaster framework has emerged as a leading contender to explain facts about the aggregate market, interest rates, and financial derivatives. In this paper we survey recent models of disaster risk that provide explanations for the equity premium puzzle, the volatility puzzle, return predictability and other features of the aggregate stock market. We show how these models can also explain violations of the expectations hypothesis in bond pricing, and the implied volatility skew in option pricing. We review both modeling techniques and results and consider both endowment and production economies. We show that these models provide a parsimonious and unifying framework for understanding puzzles in asset pricing.

Recent work suggests that the consumption disaster-based explanation of the equity premium is inconsistent with the average implied volatilities from option data. We resolve this inconsistency in a model with stochastic disaster risk (SDR). The SDR model explains average implied volatilities, even when calibrated to consumption and aggregate market data alone. We extend the benchmark SDR model to one that allows for variation in the risk of disaster at different time scales. This extension can match both the time series of implied volatilities, as well as the average implied volatility curve.